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Wednesday, May 1, 2013

Quandaries for Macroeconomic Policy: Blanchard and the IMF

The last few years have been unkind to macroeconomics. Questions that were thought to be largely settled have been reopened. Questions that didn't seem relevant to high-income economies with developed financial sectors all of a sudden seem quite relevant. The IMF recently held a conference on "Rethinking Macro Policy": the papers can be downloaded and presentations can be viewed here.
In a background paper, Olivier Blanchard, Giovanni Dell'Ariccia, and Paolo Mauro pose 12 open questions about macro policy in "Rethinking Macro Policy II:Getting Granular." Here, I'll list their 12 questions and say a few words about each.

The first five questions concern central banking.

1) Should Central Banks Explicitly Target Activity?

In the early 2000s, the rough consensus was that central banks should focus on price stability. They write: "One of the arguments for the focus on inflation by central banks was the “divine coincidence”: the notion that, by keeping inflation stable, monetary policy would keep economic activity as close as possible (given frictions in the economy) to its potential. So, the argument went, even if policymakers cared about keeping output at potential, they could best achieve this by focusing on inflation and keeping it stable. Although no central bank believed that the divine coincidence held exactly, it looked like a sufficiently good approximation to justify a primary focus on inflation and to pursue inflation targeting."
There are now a number of proposals that central banks should focus not on price stability, but on either focus on increasing the supply of money and credit in a way that would target nominal GDP or real economic activity. It's not clear how well this would work! But after the last few years, it's a reasonable question to ask.

2) Should Central Banks Target Financial Stability?

In the early 2000s, the general sense was that central banks should treat financial bubbles with "benign neglect." For example, the melt-down of the dot-com bubble in the late 1990s was unpleasant, and a short recession arrived in its aftermath. But a common argument at the time pointed out that having the Federal Reserve try to determine when the stock market (or some other financial market) is "too high" or "too low" has a lot of dangers, too. Better to let financial bubbles work themselves out, the argument went, and the central bank could focus on the real economy and mitigating recessions when needed.

But now there are proposals that the central bank should look at some financial markets, at least. For example, there seems to be some evidence that sharp rises in bank credit can be forerunners of a financial bubble that can burst into a recession.

3) Should Central Banks Care about the Exchange Rate?

Large economies like the United States have for the last few decades just let financial capital flow back and forth across their borders, with the exchange rate of their currency be determined in global financial markets. But flows of international financial capital seem to have an increasing potential for causing severe financial dislocation. Remember the east Asian crisis back in 1998, the problems of Russia and Argentina a few years later, and now the more recent experiences of Iceland, Ireland, Greece, Portugal, Spain, and who knows who's next? The practicalities of how to limit the disruptive capital flows while encouraging the productive capital flows are daunting. But they are now in the conversation of macroeconomic policy-makers.

4) How Should Central Banks Deal with the Zero Bound?

In those old pre-2007 days, most central bank policy centered on raising or lowering interest rates. But what happens when an economy is stumbling so badly that the targeted interest rate is cut essentially to zero? Blanchard, Dell'Ariccia and Mauro write: "The crisis has shown that economies can hit the zero lower bound on nominal interest rates and lose their ability to use their primary instrument—the policy rate—with higher probability than was earlier believed." The evidence on how all the various forms of quantitative easing work is still accumulating, but at present it's pretty mixed between what I would label as "useful if not enormous effects" and "not much sustained effect worth mentioning."

5) To Whom Should Central Banks Provide Liquidity?

In the old days, which refers to anything before about 2007, central banks were sometimes called the "bank for banks." They provided liquidity to banks. Other financial institutions and markets--money market funds, mutual funds, insurance companies, investment banks, securitized lending--were outside what central banks were expected to do. But in the financial crisis that erupted in 2008 and 2009, central banks around the world made all sorts of short-term loans to all kinds of financial institutions. Having set this precedent,will such loans again be provided in the future? And under what conditions, on what terms?

Their next four questions are about fiscal policy.

6) What Are the Dangers of High Public Debt?

Back in the halcyon times before 2007, very high levels of public debt were an issue for countries that seemed economically shaky for many reasons: countries in Latin America like Argentina, or Russia in the late 1990s, or in southern Europe like Turkey or even Italy, or sometimes highly-indebted countries that needed World Bank or IMF bailout plans. But public debt levels were not a first-order problem for high-income economies. They write: "At the start of the crisis, the median debt-to-GDP ratio in advanced economies was about 60 percent. This ratio was in line with the level considered prudent for advanced economies, as reflected, for example, in the European Union’s Stability and Growth Pact. ... By the end of 2012, the median debt-to-GDP ratio in advanced economies was close to 100 percent and was still increasing. ...The lessons are clear. Macroeconomic shocks and the budget deficits they induce can be sizable—larger than was considered possible before the crisis. And the ratio of official debt to GDP can hide significant contingent liabilities, unknown not only to investors but also sometimes to the government itself."

7) How to Deal with the Risk of Fiscal Dominance?

I don't actually know what "fiscal dominance" means. But the actual discussion here is about the ways in which monetary authorities can reduce the costs of debt: keeping interest rates and thus government borrowing costs low; buying and holding government debt directly; creating inflation to eat away at the real value of government debt. All of these policies have their risks, but with public debts in many countries heading to levels that would have been considered sky-high just a few years back, all possibilities are on the table.

8) At What Rate Should Public Debt Be Reduced?

They write: "[W]hile fiscal consolidation is needed, the speed at which it should take place will continue to be the subject of strong disagreement. Within this context, a few broad principles should still apply ... Given the distance to be covered before debt is down to prudent levels and the need to reassure investors and the public at large about the sustainability of public finances, fiscal consolidation should be embedded in a credible medium-term plan. The plan should include the early introduction of some reforms—such as increases in the retirement age—that have the advantage of tackling the major pressures from age-related expenditures while not reducing aggregate demand in the near term."

9) Can We Do Better Than Automatic Stabilizers?

Automatic fiscal stabilizers help ameliorate the swings of boom and bust. But should they be designed to be larger? They write: "Why not design better stabilizers? For instance, for countries in which existing automatic stabilizers were considered too weak, proposals for automatic changes in tax or expenditure policies are appealing. Examples include cyclical investment tax credits, or pre-legislated tax cuts that would become effective if, say, job creation fell below a certain threshold for a few consecutive quarters. Perhaps because the policy focus has been on consolidation rather than on active use of fiscal policy, there has been, as far as we know, little analytical exploration .. and essentially no operational uptake of such mechanisms."

The final three questions refer to "macroprudential" policies, which is one of those terms invented in the last few years. For an overview of the arguments for macroprudential policies, a good starting point is the article by Samuel G. Hanson,
Anil K. Kashyap, and
Jeremy C. Stein, "A Macroprudential Approach to Financial Regulation," in the Winter 2011 issue of my own Journal of Economic Perspectives. They write: "Many observers have argued that the regulatory framework in place prior
to the global financial crisis was deficient because it was largely
"microprudential" in nature. A microprudential approach is one in which
regulation is ... aimed at
preventing the costly failure of individual financial institutions. By
contrast, a "macroprudential" approach ... seeks to safeguard the financial system
as a whole." Thus, the traditional microprudential approach looked at each financial institution individually, to see if it had sufficient capital and risk controls. A macroprudential approach would look at overall patterns of leverage and risk, and see whether regulatory changes might be needed across the sector. But again, fresh questions arise.

10) How to Combine Macroprudential Policy and Microprudential Regulation?

Do the normal bank regulators also look at macroprudential issues? If macroprudential policy is going to involve steps like changing how easy it is to get loans, should legislators and Congress become involved? How does the central bank fit it here?

11) What Macroprudential Tools Do We Have and How Do They Work?

They write: "One can think of macroprudential tools as falling roughly into three categories: (1) tools
seeking to influence lenders’ behavior, such as cyclical capital requirements, leverage ratios, or dynamic provisioning; (2) tools focusing on borrowers’ behavior, such as ceilings on loan-to-value ratios (LTVs) or on debt-to-income ratios (DTIs); and (3) capital flow management tools." They also write: "In practice, however, implementation is not so easy."

12) How to Combine Monetary and Macroprudential Policies?

Will monetary policy and macroprudential policy be at adds? What happens when the economy is staggering and financial risks are high? The central bank looks at the staggering economy and cuts interest rates. But the macroprudential policy makers look at the high financial risks and take steps to make it tougher to borrow or to build up leverage.

Many of these policy questions come down to an question that is only answerable with the passage of time. Was what happened in the lead-in to the Great Recession a rare event, or an event that is likely to occur again in one form or another? If it was a once-a-century event, then agonizing over how to adapt macroeconomic policy is not all that useful. We can make a few tweaks, and slowly retreat back to the conventional wisdom circa 2005. On the other side, if the global economy and financial sector are increasingly prone to these kinds of upheavals, then more fundamental changes in policy-making will be needed.